For the purposes of this post I am not going to debate the merits of a Twitter (TWTR) takeover, or the validity of the frenzy of reporting over the last couple weeks that first caused a 35% gain in the stock and then yesterday’s 20% decline (see my recent commentary here and here).
But for those who figure where there’s smoke there’s fire, and maybe the reporting late this week that many of the supposed interested buyers have dropped out was just posturing, you might consider a bullish strategy that would be a tad more forgiving than merely buying the stock near $20, which is still up 40% from its 52 week lows:
To my eye, the stock has a fairly well defined 2016 range between $14 on the downside, and $25 on the upside, now trading a tad above the mid point. If the company were not to receive bids by Oct 27th, the day they are expected to report their Q3 results, and if the company were to disappoint (either on reported results, users, engagement, monetization or guidance) as they have for what seems like every quarter since their Nov 2013 IPO, then the stock could head right back to the mid teens.
Therefore, the risk/reward of buying the stock near $20 and making out ok through earnings without a bid isn’t great. But if there is renewed takeover speculation, I do believe that management and the board are not likely to allow a sale below their IPO price of $26.
I would be a buyer of the stock in the mid teens regardless. Which leads me to how I might structure a take-out trade by mid December with the risk of downside on earnings and/or no specific takeout offer. To do that I would use a risk reversal, selling an out of the money put to buy an out of the money call for the following reasons:
1. take advantage of the differential in implied volatility (the price of options) between the short put & long call. This helps to minimize the initial premium outlay by using the short put proceeds to finance the purchase of the call.
2. Better define risk on the trade entry. The purchase of long stock at current levels is dead bang loser if the stock were to gap lower. With the risk reversal I have mark to market risk in the event of a gap lower, but if I am willing to wait till expiration, the extrinsic value of the short put will decay, an I am simply on the hook for being long at the short put strike, much lower than where the stock is currently trading and at a point I’d be willing to buy (lower).
3. On the upside I have less reward on a modest move higher prior to expiration, but that is the trade-off for a better risk profile to the downside and being able to participate on a substantial move higher. This is a way to be there but only if the stock is significantly lower, or higher, with nothing done in between.
So what’s the trade?
Again, if I thought a deal could materialize in the next two months, and think the purchase price is in the high $20s, I might merely play for the home-run and pass on near term gains in place of downside risk management:
Trade: TWTR ($19.70) Buy Dec 16 / 24 Risk Reversal for even money
- Sell 1 Dec 16 put at 65 cents,
- Buy 1 Dec 24 call for 65 cents
Break-Even on Dec expiration:
Profits above $24, up 21%
Losses below $16, down almost 20%
Rationale – If the stock were to revisit recent highs on similar news, this trade would have mark to market gains and could be taken off for a profit even if a specific deal wasn’t announced. On the flip side, a move lower and you can be more patient in lieu of buying stock here as no losses need to be realized unless the stock is below the 16 strike in December.